As with the Web, Andreessen says, the more people who use the new currency, “the more valuable Bitcoin is for the people who use it.”107
“A mysterious new technology emerges, seemingly out of nowhere, but actually the result of two decades of intense research and development by nearly anonymous researchers,” writes Andreessen, predicting the historical significance of this networked currency. “What technology am I talking about? Personal computers in 1975, the Internet in 1993, and—I believe—Bitcoin in 2014.”108
What Silicon Valley euphemistically calls the “sharing economy” is a preview of this distributed capitalism system powered by the network effect of positive feedback loops. Investors like Andreessen see the Internet—a supposedly hyperefficient, “frictionless” platform for buyers and sellers—as an upgrade to the structural inefficiencies of the top-down twentieth-century economy. Along with peer-to-peer currencies like Bitcoin, the new distributed model offers crowdfunding networks like the John Doerr investment Indiegogo, which enable anyone to raise money for an idea.
As an enabling platform that sits between the entrepreneur and the market, Indiegogo captures the essence of this new distributed economic system in which anything can not only be bought or sold, but also crowd-financed.

…

If you don’t like it, walk, Uber tells its customers, with Kalanickian tact, about a service that uses “surge” pricing—a euphemism for price gouging—which has resulted in fares being 700–800% above normal on holidays or in bad weather.12 During a particularly ferocious December 2013 snowstorm in New York City, one unfortunate Uber rider paid $94 for a trip of less than two miles that took just eleven minutes.13 Even the rich and famous are being outrageously ripped off by the unregulated Uber service, with Jessica Seinfeld, Jerry’s wife, being charged $415 during that same December storm to take her kid across Manhattan.14
Along with other startups such as Joe Gebbia’s Airbnb and the labor network TaskRabbit, Uber’s business model is based upon circumventing supposedly archaic twentieth-century regulations to create a “what you want when you want it” twenty-first-century economy. They believe that the Internet, as a hyperefficient and so-called frictionless platform for buyers and sellers, is the solution to what they call the “inefficiencies” of the twentieth-century economy. No matter that much of the business generated at networks like Airbnb is under investigation by US authorities, with many of the fifteen thousand “hosts” in New York not paying tax on their rental income.15 Nor that TaskRabbit’s so-called distributed-workforce model—whose simple goal, according to its CEO, Leah Busque, is to “revolutionize the world’s labor force”16—profits from what Brad Stone calls the “backbreaking” and “soul-draining” nature of low-paying menial labor.17
“This revolutionary work built out of Silicon Valley convenience is not really about technological innovation,” warns the podcaster and writer Sarah Jaffe about the role of labor brokers like TaskRabbit in our increasingly unequal economy.

…

If the government shuts down, nothing happens and we all move on, because it just doesn’t matter.”
The Battery member and Uber investor Shervin Pishevar expressed this same techno-libertarian fantasy in under 140 characters. “Let’s just TaskRabbit and Uberize the Government,” Pishevar tweeted to his 57,000 followers.63
He might as well have said: Let’s just TaskRabbit and Uberize the economy. Let’s just turn everything into the so-called sharing economy, a hyperefficient and frictionless platform for networked buyers and sellers. Let’s outsource labor so that everyone is paid by the day, by the hour, by the minute. Because that’s indeed what is happening to the Bay Area economy, with some Oakland residents even crowdfunding their own private police force64 and Facebook (of course) being the first US private company to pay for a full-time, privately paid “community safety police officer” on its campus.65
Pishevar probably believes that unions should be Uberized and TaskRabbited, too.

In classical physics, any
number of real-world effects such as friction or air resistance are assumed
away to make mathematical analysis more tractable. Perfect vacuums and
ideal gases provide a set of simplifying assumptions that allowed for the development of theories of the physical world. Similarly, in the study of economics it is necessary to assume a construct of frictionless markets to build
a market theory out of the tools of mathematics.
This assumption of frictionless markets included instantaneous and
costless transactions devoid of real-world constraints. Buyers and sellers
bought or sold at posted prices, with no associated fees, and their actions
had no impact on the market—in the nomenclature of economics, the market participants were atomistic. Moreover, to permit sophisticated spanning
arguments and the application of fixed-point theorems from topology, it
was assumed there were securities available for every possible contingency;
every risk and possible event or state of nature not only was identified, but
was also represented by a market security.

• The efficient markets hypothesis has been challenged by various anomalies and financial crises but its main implication—that beating the market is very difficult—remains valid for most investors.
This chapter reviews the revolution in academic thinking about expected returns. Twenty-five years ago the consensus assumptions included• a world with a single risk factor—the asset’s sensitivity to the equity market (i.e., the CAPM beta);
• constant expected returns over time;
• investors care only about the means and variances of asset returns;
• frictionless markets; and
• efficient markets/rational investors.
The current view is more complex but also more realistic. There are• multiple risk factors (whose required rewards ultimately depend on their covariation with “bad times)”;
• time-varying risk premia;
• skewness and liquidity preferences (liking lottery tickets and liquid assets);
• supply–demand effects on asset prices; and
• market inefficiencies (due to investor irrationalities and/or market frictions).

…

The capital asset pricing model (CAPM), originated by Sharpe, Lintner, Mossin, and Treynor, was the profession’s first answer and, for a long time, the principal one [1].
The CAPM can be based on various sets of assumptions. I will not derive it formally here but show one traditional set of assumptions (that can later be relaxed):• one-period world (this implies a constant investment opportunity set and constant risk premia over time);
• access to unlimited riskless borrowing/lending and tradable risky assets;
• no taxes or transaction costs (i.e., frictionless markets);
• investors are rational mean variance optimizers (only caring about means and covariances can be motivated by normally distributed asset returns or by a quadratic utility function); and
• investors have homogeneous expectations (all agree about asset means and covariances; all investors see the same picture).
These assumptions ensure that every investor holds the same portfolio of risky assets, combining it with some amount, positive or negative, of the riskless asset (this latter amount depends on the specific risk aversion of a given investor).

…

The market will price assets so that the expected returns on assets with similar risks are equal. If any particular asset should offer a higher expected return due solely to the increase in the quantity outstanding, investors will soon arbitrage away such profit opportunities. Arbitrage is possible because assets are “not unique works of art” but have close counterparts in other assets or mixes of other assets (Scholes, 1972). If there are perfect substitutes and frictionless markets, buying a highexpected-return asset while selling a substitute with a lower expected return constitutes a riskless arbitrage.
Subsequent empirical studies disputed the notion that perfect substitutes exist. Demand effects may play a key role in explaining time-varying risk premia, given the lack of substitutes for market risk exposures. Even the substitutability of single stocks can be challenged.

If we can reproduce exactly the
same (random) returns as the derivative provides using a linear combination of
other marketable securities (which have prices assigned by the market) then the
derivative must have the same price as the linear combination of other securities.
Any other price would provide arbitrage opportunities.
Of course in the real world, there are costs associated with trading, these
costs usually related to a bid-ask spread. There is essentially a diﬀerent price for
buying a security and for selling it. The argument above assumes a frictionless
market with no trading costs, with borrowing any amount at the risk-free bond
rate possible, and a completely liquid market- any amount of any security can be
bought or sold. Moreover it is usually assumed that the market is complete and
it is questionable whether complete markets exist. For example if a derivative
security can be perfectly replicated using other marketable instruments, then
what is the purpose of the derivative security in the market?

…

Suppose that a security price is an Ito process
satisfying the equation
dS t = a(St , t ) dt + σ(St , t) dW t
(2.33)
Assumed the market allows investment in the stock as well as a risk-free bond
whose price at time t is Bt . It is necessary to make various other assumptions
as well and strictly speaking all fail in the real world, but they are a reasonable
approximation to a real, highly liquid and nearly frictionless market:
1. partial shares may be purchased
2. there are no dividends paid on the stock
3. There are no commissions paid on purchase or sale of the stock or bond
4. There is no possibility of default for the bond
5. Investors can borrow at the risk free rate governing the bond.
6. All investments are liquid- they can be bought or sold instantaneously.
78
CHAPTER 2. SOME BASIC THEORY OF FINANCE
Since bonds are assumed risk-free, they satisfy an equation
dBt = rt Bt dt
where rt is the risk-free (spot) interest rate at time t.

So it's no surprise to find that they are capable of tearing rents in that fabric.
Experiments at both IBM and MIT with bots in apparently frictionless markets indicate potential for destructive behavior. Not "subject to constraints that normally moderate human behavior in economic activity," as one researcher puts it, the bots will happily destabilize a market in pursuit of their immediate goals. In the experiments, bots engaged in savage price wars, drove human suppliers out of the market, and produced unmanageable swings in profitability. "There's potential for a lot of mayhem once bots are introduced on a wide scale," another researcher concluded. 25 The research suggests that frictionless markets, run by rationally calculating bots, may not be the efficient economic panacea some have hoped for. Social friction and "inertia" may usefully dampen volatility and increase stability.

We do not follow math to buried treasure and arbitrage never, ever exists.
But outside the classroom, finance professors often run around chasing arbitrage opportunities. Fortunately, the arbitrage pricing theory not only tells you how to price securities in the absence of arbitrage, it also tells you how to exploit arbitrages if they do exist.
Simply using the no-arbitrage condition and frictionless markets, we get a beautiful theory of relative asset pricing: A security can be “priced by arbitrage” in the sense that we can compute its fundamental value based on the value of other related securities. Arbitrage pricing can be done in the following three ways (of increasing complexity):
1. If two securities have the same payoffs, they must have the same value.
2. If a portfolio has the same payoff as a security, then the value of the security is equal to the price of the portfolio, which is called a replicating portfolio.
3.

…

Banks and hedge funds take the other side of this trade, making an expected profit, but not a certain arbitrage profit, as the option prices adjust to an efficiently inefficient level.5
___________________
1 See Frazzini and Pedersen (2013).
2 This version of the put-call parity requires that the stock does not pay any dividends before the option expiration. Otherwise, one must subtract the present value of the dividends on the right-hand side.
3 For American-type derivatives, one should check at every “node” in the tree whether exercise is optimal, but early exercise is not optimal for call options written on non-dividend-paying stocks in a frictionless market.
4 See Black and Scholes (1973) and Merton (1973), for which Myron Scholes (whom we meet in the interview in chapter 14) and Robert C. Merton won the Nobel Prize in 1997. (The Nobel Prize is not given posthumously, and Black passed away in 1995.)
5 Bollen and Whaley (2004) find evidence that option demand moves option prices and Gârleanu, Pedersen, and Poteshman (2009) present a model of demand-based option pricing with consistent evidence.

Failing to achieve this balance for one user base often leads to failure of the overall platform.
• Open architecture: Platforms are open systems that allow users to contribute and add value. They need to ensure that users participate regularly on the platform to ensure a vibrant cycle of value creation.
• Quality control and relevance: The open and frictionless nature of a platform leads to conflicting priorities. Being open and frictionless, platforms invite abundance. YouTube’s content and eBay’s listings speak of abundance. It is important to ensure that a platform offers quality and relevance to ensure that the abundance does not overwhelm consumers. This priority is in conflict with being open and participative and needs to be carefully architected.
• User-generated value: Since users create all the value, a platform often starts with no value.

The price of XYZ a month from today
is random: Assume that its value will either double or halve with equal probabilities.
80=S (u)
1
*
S0 =$40 HH
.
j20=S (d)
H
1
Today, we purchase a European call option to buy one share of XYZ stock for $50 a
month from today. What is the fair price of this call option?
Let us assume that we can borrow or lend money with no interest between today
and next month, and that we can buy or sell any amount of the XYZ stock without
any commissions, etc. These are part of the “frictionless market” assumptions we will
address later in the manuscript. Further assume that XYZ will not pay any dividends
within the next month.
To solve the pricing problem, we consider the following hedging problem: Can we
form a portfolio of the underlying stock (bought or sold) and cash (borrowed or lent)
today, such that the payoff from the portfolio at the expiration date of the option will
match the payoff of the option?

Methods that attempt to put a value on such things, like traffic statistics or email list count, almost always fail because there are dramatic and substantive differences between one email list and another or one visitor to a website and a visitor to a different website.
Market-Driven Comparisons
One approach that does have some theoretical reliability involves analyzing actual sale prices of comparable web properties. Websites with similar characteristics should sell for similar prices—assuming a frictionless market. This process works because, at the end of the day, a site is only worth what a real buyer is willing to pay for it. So, given enough transactions by real buyers, one should be able to deduce going market rates.
This is how it works when you are buying a house. Homes in the same general location with the same number of rooms, square footage, and amenities are considered “comparable.” Their sales prices constitute a good rule of thumb for purchase of a similar house.

He noted that descriptions of the economy overlooked obvious aspects, such as the fact that workers who relocate from one department to another within a company are responding not to the price system but to the orders of a manager, or that drafting and executing contracts often involves an awful lot of work. Coase noted that economic transactions were not easy, and that the economy was not as fluid as many of his colleagues liked to assume.
In Coase’s view, the economy was not a collection of fluid and frictionless market transactions but a set of islands of conscious power, shielded from each other and from the dynamics of the price mechanisms. Firms are hierarchical, Coase emphasized, and the interactions between a firm’s workers are often political. So in Coase’s view, hiring a worker was a form of contract in which a person was hired to do a task that had not yet been specified, since what a worker will be asked to do a few months down the road is rarely known when she is hired.

It is based not on states and intergovernmental co-operation,
but on the logic of markets and capital accumulation.
Financial crises are understood in a number of ways within this perspective.
There is, first, the neo-liberal position, the dominant political economy perspective of the present period. There are several strands within neo-liberalism. At one
extreme, neo-liberals are hyper-globalists, believing that globalisation is sweeping away all obstacles to free competition and frictionless markets (Held et al.
1999). The main obstacles that remain are nation-states and their attempts to safeguard and police their territorial jurisdictions. For these neo-liberals, the cause of
financial crises is to be sought in the powers and activities of governments, which
by intervening in inappropriate ways in financial markets, prevent them from
working as they should and precipitate crises. In completely free markets, financial crises would not occur, or at least there would be only mild fluctuations and
adjustments.

Customers can comment on the contractors they’ve hired, which means that, even if you don’t know anyone who’s worked with a particular plumber, you at least have some indication of whether he knows what he’s doing, how fast he works, and how accurate his estimates usually turn out to be. And you’ll know whether he tracks mud in his customers’ houses or smokes in their bathrooms, because Angie’s List will tell you all that, for a fee. Essentially, once you find yourself outside the frictionless world of perfect markets, there’s a potential role for an intermediary to sit between the two sides.14
Lots of market evangelists have taken the notion that better technology and more nuanced feedback algorithms will end the informational problems that were the focus of Akerlof, Spence, and other information economists. One article on the libertarian Cato Institute’s website recently trumpeted in its title that we are approaching “The End of Asymmetric Information.”

And potential renters clearly found that the hassle and uncertainty of dealing directly with Nick outweighed the benefits (nothing personal, Nick).
What Nick and others couldn’t do, platform-based companies like Zipcar could. It takes a company, like Zipcar, to build robust platforms that make it simple for peers to participate and to exploit the excess capacity identified. Think about what it takes to forge a resilient, frictionless platform for peer-to-peer car sharing. Acquiring the appropriate group insurance is at best a year-long effort (and at worst five years and counting in the United States) that no individual or insurance company would ever undertake for just one person’s policy. Nor could an individual get the benefits of a bulk discount. Few individuals have the skill and the capital to build the Apple iOS and Google Android apps that enable people to find and rent a car quickly, or to create the hardware that unlocks the car doors and enables the ignition.

Far from losing a sense of identity younger generations growing up with the web seem both more individualistic and more collaborative than their elders. That is not to say that these critics do not raise important points, but they are qualifiers, not the main story.
The fourth group argue the net will be mainly good for us. The members of this group, however, differ over why and how the net will be useful for society.
The libertarian, free market wing believe the Internet is creating more diversity and choice, resulting in faster, frictionless markets and an abundance of free culture. In fact, the web is no less than a capitalist cornucopia. Chris Anderson, the editor of Wired and author of The Long Tail is the cheerleader for this camp.
The communitarian optimists take a contrary view. They see in the Internet the possibility of community and collaboration, commons-based, peer-to-peer production, which will establish non-market and non-hierarchical organisations.

The “rational expectations” revolution, which took as its premise that individuals do not make systematic prediction errors about the future course of the economy, gave us a better appreciation of the role that anticipatory, forward-looking behavior by firms, workers, and consumers plays in shaping economic outcomes. The “efficient market hypothesis,” built on the joint supposition of rational expectations and frictionless markets, taught us about the good that financial markets can do in the absence of transaction costs. These ideas made useful contributions to economics and to economic policy. But they did not upend everything we already knew. They simply gave us additional tools with which we could anticipate the economic consequences of different circumstances.
An honest practitioner of academic economics should respond with a blank stare when asked what the implications of his work are for policy.

It can’t. Since price dispersion continues to exist, it must be that even internet markets are subject to frictions—there are still some transaction costs. These are not costs of locating sellers or learning their prices, for those costs are close to zero. The remaining transaction costs are more subtle. They come from difficulties of observing quality. The internet has not created perfectly frictionless markets. The need for buyers to be able to trust sellers has been heightened by the internet.
The hype notwithstanding, the internet in fact has not made information free. If shopping were merely a matter of finding the lowest price, the internet’s comparison shopping devices would eventually force all retailers to match their lowest-priced competitors. But a book offered by one retailer may be distinguishable, in a shopper’s perception, from the same book offered by another retailer, even though they are physically identical objects.

This means
that, across countries, the burden of taxation disproportionately falls among
the least mobile factors, which are those production factors literally cemented
to their localities, such as single-plant factories. This is important because
it suggests country-specific effects do indeed exist. Thus, I contend changes
in national economic policies produce systematic deviations from PPP. To
the extent these deviations can be anticipated, I also contend investors and
portfolio managers who are tuned in to location effects can sail with the wind
at their backs.
In a frictionless world, production factors and the mobility of goods and services guarantee differences in rates of return are arbitraged away. In such an idealized world, PPP holds. This means, as long as there is no deviation from PPP,
rates of return are identical across national markets. This is a potent insight
and it has two distinct implications. First, if the regulatory burden is of a fixedcost nature, corporations have an incentive to increase their operations’ scale
186
UNDERSTANDING ASSET ALLOCATION
to minimize the regulatory burden’s impact.

The site shut down not long after one dealer duped dozens of users out of many thousands of dollars, and shortly a competing site launched, The Euphoric Knowledge. Its server was hosted in Holland, and soon enough dozens more group buys and swaps and sales kicked off. The site was mainly populated by young men who bought and sold designer drugs to each other with an enthusiasm and blatancy that was matched only by their carelessness. This Facebook generation, so accustomed to sharing information openly and indiscriminately in a frictionless world where an acquaintance or an adserver alike are trusted with access to your most private information, was lulled into a false sense of security by the lack of action in the US in the years following Operation Web Tryp – in the unlikely event that they had ever heard of it.
Quite how anyone believed that a site such as The Euphoric Knowledge could continue to run is anyone’s guess, but for a while, it was one of the busiest spots for the research, purchase and sale of some extraordinarily rare and potent compounds that, just a few years before, were known perhaps to a few thousand people worldwide.

The effect on the portfolio the private sector owns directly is offset by the effect on the government portfolio that the private sector also owns, albeit quite indirectly.24 That is, if the government lost money by purchasing private mortgage-backed securities that went into default, it is the public that would eventually have to pay the higher taxes to cover the losses. A hyper-rational taxpayer in a frictionless world would internalize this risk and adjust her own portfolio accordingly. In the extreme limit, exchanges between public and private portfolios have no effect; when the government issues short-term debt and goes into private markets to buy long-term debt, there is no net effect, because the exchange is “all in the family.” I realize that this conceptual exercise of first noting that the government owns the central bank and then that the public owns the government does make a government bond seem a little bit like a Russian nesting doll (a matryoshka).25
In the real world, many imperfections make government debt operations consequential, but if the starting point is neutrality, one can get very different answers than if one uses the crude Keynesian assumption of pretending that the government is an entity entirely unto itself.

That sad tale is the story of the next chapter.
11
Collecting nickels in front of steamrollers
The previous chapter looked at the monumental risks that have built up in a system dedicated to the management, dispersal, and efficient pricing of risk. There’s quite a paradox here. Financial markets are often said to come as close as is possible to the economists’ ideal of a competitive, well-informed, frictionless market. If neoclassical economic theory made any kind of sense, financial markets should be its showcase: the best possible example of markets in action.
Unfortunately, markets don’t follow theory; they prefer reality. And reality is messy, full of compromise and skewed, absent, or contradictory incentives. As long as those incentives are so badly flawed as they are now, the system will always create risks that threaten to destroy the entire capitalist system.

As a consequence, Bachelier and Samuelson argued that any advantageous information that may
lead to a proﬁt opportunity is quickly eliminated by the feedback that
their action has on the price. Their point is that the price variations in
time are not independent of the actions of the traders; on the contrary,
it results from them. If such feedback action occurs instantaneously, as
in an idealized world of idealized “frictionless” markets and costless
trading, then prices must always fully reﬂect all available information
and no proﬁts can be garnered from information-based trading (because
such proﬁts have already been captured). This fundamental concept introduced by Bachelier, now called “the efﬁcient market hypothesis,” has a
strong counterintuitive and seemingly contradictory ﬂavor to it: the more
active and efﬁcient the market, the more intelligent and hard working the
investors; as a consequence the more random is the sequence of price
changes generated by such a market.

Like Santa Monica’s smart parking system, this would maximize local and economic efficiency—but only at the cost of decreasing global and deliberative efficiency. Automating virtue in one instance, as we have already seen, might require automating it everywhere—not to mention that, in the context of energy, it might result in more reckless consumption overall.
The Caterpillar’s designers see friction—not efficiency or ease of use—as a productive resource that, properly deployed, can highlight complex issues that are very hard to see in a frictionless world.
Another of their transformational products is a Forget Me Not reading lamp. Once switched on, Forget Me Not starts closing like a flower, as its light gradually gets dimmer and more obscure. For the lamp to reopen and shine again, the user needs to touch one of its petals. Thus, the user is in a constant dialogue with the lamp, hopefully aware of the responsibility to use energy appropriately.

The existence of bid-ask spread, although small in magnitude, has several important consequences in time series properties of asset returns. We briefly discuss the
bid-ask bounce—namely, the bid-ask spread introduces negative lag-1 serial correlation in an asset return. Consider the simple model of Roll (1984). The observed
market price Pt of an asset is assumed to satisfy
S
Pt = Pt∗ + It ,
2
(5.9)
180
HIGH - FREQUENCY DATA
where S = Pa − Pb is the bid-ask spread, Pt∗ is the time-t fundamental value of the
asset in a frictionless market, and {It } is a sequence of independent binary random
variables with equal probabilities (i.e., It = 1 with probability 0.5 and = −1 with
probability 0.5). The It can be interpreted as an order-type indicator, with 1 signifying buyer-initiated transaction and −1 seller-initiated transaction. Alternatively, the
model can be written as
+S/2 with probability 0.5,
Pt = Pt∗ +
−S/2 with probability 0.5.

Like Bachelier, they relied on a model of variation in prices—Brownian motion—although unlike Bachelier, they chose one that did not allow prices to become negative—a limitation of Bachelier’s work.
The Black-Scholes formula, as it is now referred to, was mathematically sophisticated, but at its heart it contained a novel economic—as opposed to mathematical—insight. They discovered that the invisible hand setting option prices was risk-neutral. Option payoffs could be replicated risklessly, provided one could trade in an ideal, frictionless market in which stocks behaved according to Brownian motion. Later researchers4 developed a simple framework called a “binomial model” that was able to match the payoff of a put or a call by trading just the stock and a bond through time. These solutions to the option pricing problem linked finance and physics together forever afterward. In fact, it turned out that the Black-Scholes option pricing model was the same as a problem in thermodynamics—a “heat” equation, in which molecules—not stock prices—were drifting randomly.